Accounting Unit 1 Notes
Chapter 1- The Nature and Role of Accounting in Small Business
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Accounting is the collection, recording and reporting of financial information to
assist business owners in decision-making
Accounting is a process that turns day-to-day operations of a small business into a
form that the owner can study to determine which areas of their business needs
improvement
The purpose of accounting is to provide business owners with financial
information that will assist them in making decisions about the activities of their
firm
‘Users’ of accounting are different parties that maybe interested in a firms
financial information, and may include:
 Owner
 Manager; when the owner is also not the manager
 Debtors and other customers, who may wish to know about the firms
ability to provide them with stock
 Creditors and other suppliers, who may wish to know the firms
ability to repay what it owes them
 Banks and other financial institutions, which will certainly want to
know about the firm’s current level of debt and their ability to repay
before providing them with any additional finance
 Employees, who may wish to know about the firm’s long-term
viability- and their own long-term employment prospects- or its
ability to afford improvements in wages and conditions
 Prospective Owners, who may wish to know about the firm’s
financial structure and earnings performance, and its assets and
liabilities to determine the firm’s worth
 Government- Australian Taxation Office, which will require
financial information for taxation purposes
Financial data is the raw facts and figures upon which financial information is
based, most of the facts and figures come from source documents
Financial information is financial data which has been sorted, classified and
summarised into a more usable and understandable form
The process of turning financial data into financial information is facilitated by
what is known as the accounting process:
1. Collecting source documents- also known as the input stage, this is
where business collects the source documents relating to its
transactions
2. Recording- once the source documents have been collected, the
information must be recorded. Recording involves sorting,
classifying and summarizing the information contained in the source
documents so it’s more usable. Common accounting record include
journals and stock cards
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3. Reporting- the preparation of financial statements that communicate
financial information to the owner. The three main types of reports
used are statement of receipts and payments, profit and loss
statement and a balance sheet
4. Advice- the provision to the owner of a range of options appropriate
to their aims/objectives, and recommendations as to their suitability.
Armed with information presented in the reports, an accountant
should be able to make some suggestions on appropriate course of
action. Without proper advice, the information in the reports are
useless, but if the reports are explained carefully and the accountant
provides the owner with a range of options, a more informed
decision
A transaction is an agreements between two parties to exchange goods or services
for payment
Source Documents are the pieces of paper that provide both the evidence that a
transaction has occurred, and the details of the transaction itself. Common source
documents include:
 Receipts, which provide evidence of cash received by the business
 Cheque butts, which provide evidence of cash paid by business
 Invoices, which provide evidence of credit transactions
 Memos, which provide evidence of transactions within the firm itself
 Bank Statements, which not only verify the cash transactions of the
business but also provide evidence of transactions that the business
may have been unaware of, such as the receipts of interest or the
charging of a service fee
Common accounting records include:
 Journals, which record daily transactions of a common type (such as
all cash paid, all cash received, or all stock paid on credit)
 Stock Cards, which record all the movements of stock in and out of
the business
There are three general-purpose reports that all business should prepare:
 Statement of Receipts and Payments, to report on the cash the firm
has received and paid, and the change in its bank balance over a
period
 Profit and Loss Statement to report on the firms revenues and
expenses over a period
 Balance Sheet to report on the firm’s assets and liabilities at a
particular point in time
Accounting Principles are the ‘generally accepted rules’ that govern the way
accounting information is recorded
The seven principles that govern the way accounting information is recorded are:
1. Entity Principle- states that from an accounting prospective, the
business is separate from the owner and other entities, and its records
should be kept on this basis. If we are to assess the performance of
the business itself, we must only include information that is relevant
to the business
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2. Going Concern Principle- assumes that the life of the business is
continuous, and its records are to be kept on that basis. This principle
allows us to record transactions that affect the future of the business.
Also we will be able to recognize long-term assets and liabilities and
distinguish them from short term ones.
3. Reporting Period Principle- states that the life of the business must
be divided into periods of time to allow reports to be prepared, and
the accounting records should reflect the period in which the
transaction occurs. Because the life of the business is assumed to be
continuous, it is necessary to divide that life into arbitrary periods so
that reports can be prepared. Reporting periods can be as short as the
owner requires but not longer than a year to meet taxation
requirements.
4. Historical Cost Principle-states that transactions should be recorded
at their original purchase price, as this value is verifiable by source
document evidence. This particularly applies to assets which must be
recorded at their original price, any other valuation such as
resale/replacements values are only estimations and could be biased.
5. Consistency Principle- states that accounting methods used by the
business should be kept the same from one period to the next, so that
you can compare reports.
6. Conservatism Principle- states that losses should be recorded when
probable, but gains only when certain so that liabilities and expenses
are not understated and assets and revenues are not overstated. This
principal advocates a worst-case scenario approach to accounting.
Because the accounting system may contain estimates, accountants
should view records and reports conservatively/cautiously.
7. Monetary Unit Principle- states that all items must be recorded and
reported in the currency of the country of location where the reports
are being prepared. This makes everything consistent and
comparable.
While principles govern the way accounting information is recorded, reports are
prepared under the guidance of what is known as the International Framework,
the framework identifies what the reports should include and the qualities the
report should possess
Qualitative Characteristics are basically the qualities that we would like our
accounting information to possess. The four Qualitative Characteristics are:
 Relevance- states that reports should include all information that is
useful for decision-making, and exclude all information which is not.
This information should be up-to-date, relate solely to the business
and be appropriate to the decision at hand. If we follow the Entity
and Reporting Period principles then this characteristic will be
present. Relevance also relates to what to include in terms of
material, this refers to the level of detail information is shown.
 Reliability- states that reports should contain information verified by
source document evidence so that it is free from bias, and can be
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relied upon for its accuracy. This tells us that we should avoid the
use of estimates. Reliability will be assisted via the Historical Cost
Principle, because the best way to ensure that information is free
from bias is to make sure it is verifiable by source documents.
 Comparability- states that reports should be comparable over time,
and between different companies, through the use of consistent
accounting procedures. The reports are mainly use to compare
between periods and companies and this will only be possible if
consistent accounting methods have been used.
 Understandability- states that reports should be presented in a
manner that makes it easier for the user to understand their meaning.
Chapter 2- The Accounting Equation
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The financial position of a business can be represented in two ways:
1. In a form of an equation- the Accounting Equation
2. In preparing a formal accounting report known as the balance sheet
The assessment of the firm’s financial position will consider the economic
resources it controls (its assets) and its obligations (its liabilities, thus allowing the
owner to assess their owners’ equity- the net worth of their investment in the
business
An asset is a resource controlled by the entity (as a result of past events) from
which future economic benefits are expected
An asset can be physical (such as a motor vehicle) or intangible (such as a
trademark), that assist business actually carry out operations to earn revenue
An asset is most likely owned by the business, but it is not necessary that the item
is owned to be classified as an asset: all that is required is that the business has
control of the item, this means the business must be able to determine how and
when it is used
An asset has to be capable of bringing the firm an economic benefit some time in
the future
Liabilities are present obligations of the entity (arising from past events), the
settlement of which is expected to result ion an outflow of economic benefits
Only debts that are presently obliged to make should be recognized as liabilities
The fact that a liability is expected to result in an outflow of economic benefited
means that the outflow- or sacrifice- is yet to occur, a liability can be seen as a
future economic sacrifice
Owner’s Equity is defined as the residual interest in the assets of the entity after
the deduction of its liabilities
Equities are claims on the assets of the firm, consisting of both liabilities and
owner’s equity
Liabilities are what business owes to external parties, while owner’s equity is
what the business owes to the owner, and both of these claims must be funded
from the business’s assets
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The relationship- between assets, liabilities and owner’s equity- is known as the
accounting equation:
Assets = Liabilities + Owner’s Equity
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The accounting equation has the same affect on all business’s, and all reporting
entities are subject to one fundamental accounting law: the Accounting equation
must balance, this means the worth of assets must always equal liabilities plus
owner’s equity
The equation always balances because the owner receives the residual (left over)
interest after the liabilities are deducted
The relationship- between assets, liabilities and owner’s equity- as described by
the Accounting equation- is the heart of the balance sheet
The balance sheet is an accounting report that details a firm’s financial position at
a particular point in time by listing its assets and liabilities and the owner’s equity
The title of the report refers to who the report is prepared for, what type of report
it is and when it is accurate
The balance sheet is always titled “as at” because it reflects the fact that a Balance
Sheet is only ever accurate on the day it is prepared
The elements of the Accounting equation- assets, liabilities and owner’s equity
provide the headings within the Balance Sheet
The usefulness of a balance sheet can be improved by classifying the information
it contains
Items in the balance sheet can be classified whether they are current or noncurrent
A current asset is a resource controlled by the entity (as a result of a part event),
from which a future economic benefit is expected for 12 months or less
A non-current asset is a resource controlled by the entity (as a result of a part
event), from which a future economic benefit is expected for more than 12 months
A current liability is an present obligation of the entity (arising from past events),
the settlement of which is expected to result in an outflow of economic benefits in
the next 12 months
A non-current liability is an present obligation of the entity (arising from past
events), the settlement of which is expected to result in an outflow of economic
benefits sometime after the next 12 months
When classifying loans it is important to recognize that some of the amount
owing may be current, and some non-current, therefore the installment of the loan
which is due in the next 12 months is current and the rest is non-current
Every transaction will change at least two items in the accounting equation, but
after those changes are recorded the Accounting equation must still balance, this
is known as double-entry accounting
The two rules of double-entry accounting is:
1. Every transaction will affect at least two items in the accounting
equation
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2. After recording these changes, the accounting equation must still
balance
The rules of double accounting also apply to the Balance Sheet
The classification of items in the balance sheet as current or non-current enhances
the usefulness of the report because it allows for the calculation of performance
indicators
These indicators or ratios compare items within the Balance Sheet in order to
assist management in determining the financial health of the business
An indicator is a measure that expresses profitability or liquidity in terms of the
relationship between two different elements of performance
Liquidity is the ability of the business to meet its short-term debts as they fall due
A popular measure of liquidity is the Working Capital Ratio (WCR), this
indicator compares a firm’s current assets and current liabilities to determine
whether the business has sufficient economic resources to cover its present
obligations
Working Capital Ratio: formula
Working Capital Ratio (WCR) = Current Assets
---------------------Current Liabilities
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Working Capital Ratio (WCR) is a liquidity indicator that measures the ratio of
current assets to current liabilities to assess the firm’s ability to meet its short term
debts
As long as the Working Capital Ratio (WCR) is above 1:1 then this would
indicate sufficient liquidity, as there are enough assets to cover the current
liabilities of the business
A Working Capital Ratio that is too high may indicate that the business has an
overabundance of current assets that are not being employed effectively
Stability is the ability to meet long-term obligations
Whereas liquidity focuses on short-term, stability concentrates on the firms ability
to meet its obligations in the longer term
A good indicator of stability is Gearing, which measures what percentage of the
firms assets are funded by external sources
Gearing is the proportion of the firm’s assets that are funded by external sources
Gearing: formula
Gearing =
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Total Liabilities
-------------------Total Assets
x 100
There is no set level which Gearing is said to be satisfactory but it is a good
indicator of financial risk. High Gearing means that a high proportion of the
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firm’s assets are funded by external sources, this in turn puts pressure on the
firm’s cash flow to meet principle and interest repayments, and therefore a greater
risk of financial collapse. Gearing will be increased by borrowing by the business,
also changes in owner’s equity will affect gearing not only changes in assets and
liabilities. Excessive drawings that decrease owner’s equity will increase Gearing
and the risk of the business as well as affecting the level of liquidity, However,
capital contributions by the owner can reduce gearing and the financial risk of the
business as well as providing short-term relief to liquidity
Chapter 6- Source Documents
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Source documents are pieces of paper that provide both the evidence that a
transaction has occurred, and the details of the transaction itself
The information communicated to the owner via the reports is the product of the
recording system which summarises and classifies transactions. But the records
themselves are generated from the raw data provided in source documents: they
provide the facts on which all subsequent accounting information will be based
Source documents have two separate yet related functions:
1. They provide verifiable evidence of the details of a transaction, thus
ensuring that the information in the accounting reports will be
reliable- free from bias or subjectivity and accurate
2. They provide the evidence that is required by the Australian Tax
Office (ATO) relating to the firm’s income tax and Goods and
Service Tax (GST) obligations
Due to their importance, source documents must be stored and filed in a safe and
organized manner
GST (Goods and Service Tax) is a 10% tax levied by the federal government on
sales of goods and services
GST applies to most goods and services except fresh food
Under the current GST system, the federal government taxes consumers 10% of
the price of whatever they have purchased, with the business that sells the
goods/service acting as the tax collector for the ATO. At the same time any GST
the business pays to its suppliers will reduce the amount it owes to the ATO
The need to verify the amount of GST owed to the ATO means it is essential that
the business has accurate information relating to:
 The GST it has collected on its sales or service (which it owes to the
ATO)
 The GST it has paid to its suppliers (which reduces the GST owed to
the ATO)
As a consequence of GST, source documents must include the following
information:
 The words ‘tax invoice’ stated clearly
 The name of the seller
 The ABN (Australian Business Number) of the seller
 The date of the transaction
 A description of the item/goods provided
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 The price of the transaction including the GST
 The amount of GST
 (Fees of more than $1000 must also show the name, and address or
ABN of the buyer)
Without the above details, the source documents cannot be used to substantiate
GST transactions
Cash transactions fall into one of two categories- cash receipts or cash payments
The term ‘cash receipt’ can refer to both the transaction that occurs when cash is
received from another entity, as well as the source document that verifies that
transaction
All cash received must be evidenced by:
 A cash receipt (hand-written or generated electronically)
 A cash register receipt
Cash receipts should be issued each and every time cash is received, whether is
for a cash sale/ cash fees, a capital contribution, a receipt of a loan or some other
source. The only exception is when cash is deposited straight into the forms bank
account, in which the source document will be the bank statement
As a source document the, a receipt must specify the date of the transaction, the
amount received, and the reason for the receipt of cash, also it must contain all
information necessary to account for GST
When a register generates a cash receipt it produces the original for the customer
while a copy is kept for the business
Some trading businesses will not provide an individualized receipt (businesses
that sell larger, more expensive items) to each and every customer, instead
preferring to issue a cash register receipt ( businesses that sell goods in large
quantities)
The owner can examine the ‘cash register roll’ or an equivalent to, to generate a
summary of the cash received in a single day’s trading. If a business sells a
variety of items the register is set to distinguish between certain classes of
products
At the time a cash sale is made, the business receives the cash for the service, plus
the GST, and this must be documented on the receipt. While the business keeps
the cash for the service, the GST is owed to the government, so this creates a GST
liability
All cash payments should be able to be evidenced by a source documents, most
frequently for cash payments this is a cheque butt
Cash payments should be primarily made by cheque
When a business pays by cheque, the cheque itself is given as payment, and the
cheque butt us retained by the business (as the source document)
Using cheque as a method of cash payments provides a level of protection that is
not possible with actual notes and coins, as:
 Cheques means that that the owner can avoid carrying around large
amounts of cash
 Cheques can be traced to identify the business or individuals that
deposited the funds into their account
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 The cheque butt that is retained after every payment provides
evidence of the transaction (the amount and use of cash)
The cheque itself is a document informing the bank to transfer funds from the
account of the drawer to the bank and account of the payee
The drawer is the entity writing the cheque
The drawee is the financial institution or bank of the drawer
The payee is the entity that is that is receiving the cheque or to whom the cheque
is written to
Cheques should not be made out for cash when paying for costs as if the cheque is
lost it can be cashed or deposited into any account
It is a sensible practice to nominate the payee and the cheque ‘not negotiable,’ this
means that is can only be deposited into the account of the nominated payee
‘Not negotiable’ is a control mechanism that ensures that the cheque can only be
deposited into the account of the nominated payee
Even though a cheque is signed by the owner, the business is recognized as the
drawer, as the bank account belongs to the business, and its is the business that is
drawing on its account to pay for the cost
Even if a cheque is cancelled, the cheque butt should be completed so that the
cheque can be accounted for
At the time a cash payment is made, the business will pay cash for whatever it is
purchasing, plus GST on that amount, and this should be documented on the
cheque
If a business has paid any GST to its suppliers, it is allowed to deduct this from
the GST it owes; because the GST will be forwarded to the ATO by the firm’s
suppliers, it is treated as if the business has paid the GST straight to the
government; thus GST paid to suppliers will decrease a firm’s GST liability;
because of the it is possible to have a GST asset is the firm has paid more GST
than it has received
Cash payments cannot always be made in forms of cheques, alternative methods
are:
 A petty cash system- under this system a small amount of cash is set
aside with individuals reimbursed from the petty cash fund for small
amounts that they have paid on behalf of the firm
 The business may use debit or credit cards for purchases
 Phone and internet banking to transfer cash electronically from one
account to another
Regardless of which method of payment is used, the basic principles of cash
recording still apply, and the source documents must be kept to verify thee
amount, and the use of the cash
A credit transaction effectively separates a sale or purchase into two transactions:
an exchange of goods or a service, and an exchange of cash which doesn’t occur
until a later date
With cash transactions, the sale or purchase of a good or service occurs at the
same time as the cash is exchanged
An invoice is a source document to verify a credit transaction
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The invoice must show all the information for it to be classified as a tax invoice
The seller or supplier will have its name at the top of an invoice
The purchaser or customers name is in the middle of the invoice
The original of the invoice is sent to the customer while the copy is retained by
the seller for recording purposes
Some transactions will no be able to be evidenced by any of the above documents,
as they involve neither a sale nor purchase, nor the receipt or payment of cash,
but those documents can be evidenced by a memo which is issued form within the
firm
A memo is a source document used to verify an internal transaction
The format of the memo is more flexible than other documents, simply they will
describe a particular transaction, and request that it is recorded
Chapter 7- Cash Accounting For Service Businesses
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Small businesses can be classified according to the nature of its operations as a
service business, trading business or a manufacturing business
A service business is a small business which operates by providing its time,
labour or expertise (or a combination of all three) in return for a fee or a charge
The majority of transactions in a service business are cash transactions
As many of the transaction in a service business involve cash, the accounting
system must be able to generate information relating to the firm’s cash position,
this information should cover:
 Cash receipts- the amount of cash the business has received from
other entities during a period, and its sources
 Cash payments- the amount of cash the business has paid to other
entities and its uses
 Bank balance- the level of cash on hand at a particular point in time
When we speak of ‘cash’ we are not only talking about the notes and coins in the
cash register (i.e. cash on hand), but also about cash in the firm’s bank account,
and any cheques it may have received from customers
Cash in the firm’s bank account and cheques are not strictly dollars and cents , but
they are very easily changed into dollars and cents: cash in the bank account
easily can be withdrawn easily, and cheques once deposited, convert into cash
within a few days
Accounting information is communicated to the owner via written reports, but
these reports themselves are based on information generated by the recording
system
The first step in generating information about a firm’s financial position is to
collect the source documents relating to the cash it has received and paid during
the reporting period
The main documents used to verify transactions where cash is received are:
 Cash receipts
 Cash register roll
 Bank statement
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The main documents used to verify transactions where cash is paid are:
 Cheque butts
 Bank Statements
Once the relevant documents have been collected and sorted, it is necessary to
record the data they contain into journals
A journal is an accounting record which classifies and summarises transactions
during a particular reporting period
Cash transactions are recorded into one of two journals:
 Cash Receipts Journal- summarises all cash received by the business
(from other entities) during a particular Reporting Period
 Cash Payments Journal- summarises all cash paid by the business (to
other entities) during a particular Reporting Period
By recording the cash transactions in a Cash Receipts Journal and a Cash
Payments Journal, the raw data contained in the source documents is classified
and summarised so that it becomes information which can be presented in
accounting reports
The penultimate stage is the preparation of accounting reports to communicate
financial information to the owner
For cash transaction, this means taking the information which has been generated
in the Cash Receipts Journal and the Cash Payments Journal, and preparing a
Statement of Receipts and Payments
The Statement of receipts and payments shows the firm’s cash receipts and
payments and the consequent change in its bank balance over that Reporting
Period
The Statements of Receipts and Payments is an accounting report which lists cash
receipts and payments during the Reporting period, the change in the bank
balance, and the opening and closing bank balance
Single-entry accounting is the process if recording transactions in journals and
then using the summarised information to prepare reports
Transactions must be classified and summarised so that the business has
information rather than just data, and this achieved by recording cash receipts and
payments into journal
Cash Receipts Journal is an accounting record which summarises all cash
received from other entities during a particular Reporting Period
Notes recording in a Cash Receipts Journal:
1. Date/Details/Rec. No.- As with most accounting records, transactions are
recorded in the Cash receipts Journal in date order, with a brief description of
the transaction noted in the details column. In order to satisfy demands of
‘reliability’, the source document- which in this case is a receipt number- is
recorded with the transaction. The receipts number should run in sequential
order as they are issued by the firm itself.
2. Bank- The amount of cash received is entered in the Bank column to allow
calculation of the total cash received for the Reporting period.
3. Classification columns- in a multi-column Cash receipts Journal, each cash
receipt must be recorded twice- once in the bank column and a second time in
a classification column to record the source of that cash. These classification
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columns allow for frequent cash receipts to be summarised, that only the total
needs to be reported in the Statement of Receipts and Payments. There is
nearly always a GST column. By classifying their receipts a business is able to
gain more information.
4. Sundries- any receipts that are infrequent should be recorded in the sundries
column, because it is not necessary to summarise transactions that only occur
once.
The double-checking mechanism can be used to see whether the recording and the
figures are correct. At the end of the period, each column in the Cash Receipts
Journal should be totaled. As a Double checking mechanism, the bank column
should equal the sum of the totals of the other (classification and sundries)
columns.
All GST collected form sales is owed to the ATO, so this creates a GST liability
Not all transactions have GST attached to them as it is not a transaction resulting
in the sale of a r the performance of a service, such:
 Interest Revenues (on bank accounts, term deposits or other
investments)
 Capital contributions
 Loans
 Wages
 Drawings
 Commercial rates
Cash Payments are classified and sorted in a Cash Payments Journal
A Cash Payments Journal is an accounting record which summarises all cash paid
to other entities during an particular Reporting period
The differences in recording in Cash Payment Journals than Cash receipt Journals
are:
1. Date/Details/Ch. No.- The date and details are the same. But for cash
payments the source document is the cheque number which is identifiable
from the cheque butt. All cheque numbers should be recorded so all cheques
can be accounted for.
2. Bank- The amount of each cash payment must be recorded in the ‘bank’
column, to allow calculation of total cash payments for the period.
3. Classification column- Is the same as the Cash Receipts Journal. It allows the
classification of frequent cash payments. There is nearly always a GST
column.
4. Sundries- Also the same as the Cash Receipts Journal, it allows the recording
of infrequent cash payments.
The double-checking mechanism also applies for the Cash Payments Journal
As any GST paid to suppliers will be forwarded to the ATO, thus GST paid to
suppliers decreases the GST liability
The cash journals does not provide a complete assessment of a firm’s cash
situation because they do not show:
 The firm’s bank balance at the start of the period
 The firm’s bank balance at the end of the period
 The overall change (increase or decrease) in the firm’s bank balance
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Due to the above reasons we need to prepare a Statement of Receipts and
Payments, which provide a full assessment of the firm’s current cash situation
As with all accounting reports the title of the statement identifies who the report is
prepared for, what type of report it is and when- which period it applies
The totals of the classification columns and the individual amounts listed in the
Sundries column are reported under the headings of Cash Receipts and Cash
Payments, depending on the journal in which they were recorded, this include a
GST column in both the payments and receipts headings
The overall change in the firms bank balance- known as the surplus or deficit- can
be calculated by deducting the total cash payments form the total cash
receipts
Surplus (Deficit) = Cash Receipts – Cash Payments
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A cash surplus occurs when there is an excess of cash receipts over cash
payments, leading to an increase in the bank balance
A cash deficit occurs when the is an excess of cash payments over cash receipts,
leading to a decreases in the bank balance
The opening bank balance represents how much cash is available in the firm’s
account at the start of the period. The opening bank balance is the same s the
closing bank balance in the last period.
The closing bank balance represents how much cash is available to the firm
currently. It is calculated by adding the surplus or deficit to the opening bank
balance. It is reported as Bank in the balance sheet. If the bank balance is positive,
then ‘Bank’ will be reported as an current asset; if the balance is negative then
‘bank overdraft’ will be reported as a current liability
Closing Bank Balance = Opening Bank Balance + Surplus (Deficit)
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The difference between a cash deficit and a bank overdraft is; a deficit refers to a
decrease in a firm’s bank balance- the change- but it does not necessarily mean a
negative balance. An overdraft refers to a negative balance, it describes not a
change but a level of cash.
The Statement of Receipts and Payments summarises all information relating to a
firm’s cash position, this then can help the owner make decision about the firm’s
receipts, payments and the level of cash on hand. A high bank balance might
indicate the ability to make higher loan repayments, take greater drawings,
purchase newer non-current assets, or undertake other expansionary activities. A
low bank balance might indicate the need for lower loan repayments, lower
drawings, the use of credit for some purchases, or even a capital contribution by
the owner.
When a business receives GST, it does so on behalf of the government, so the
business owes GST to the ATO. However if a business has paid GST to its
suppliers it is allowed to deduct this from the GST it owes. At the end of the
period the firm must calculate its overall GST balance.
As selling prices are usually higher than cost prices, GST received on fees will
usually be greater than GST paid to its suppliers. Therefore most businesses will
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accrue a liability n relation to GST called ‘GST Payable.’ GST payable is a
current liability, as it is a present obligation which is expected to result in the
outflow of economic benefits. When GST is payed to the ATO it is known as a
GST settlement. GST settlement is recorded in the Cash Payments Journal, and is
classified in the ‘sundries’ column.
GST payable is GST owed by the business to the ATO when the amount of GST
the business has received on its fess is greater than the GST it has paid to its
suppliers
GST settlement is a payment made to the ATO be a small business to settle GST
payable
If a business makes bulk purchases of goods or purchases non-current assets, then
it is possible that GST paid to its suppliers is greater than the GST received. In
this case this is called ‘GST receivable’ from the ATO. GST receivable is a
current asset as it can expect and economic benefit. A ‘GST refund’ would be
recorded in the Cash Receipts Journal in the Sundries column
GST receivable is GST owed to the business by the ATO when the amount of
GST the business has paid to it suppliers is greater than the GST it has received
on it fees
GST refund is a cash receipt form the ATO to clear GST receivable
Chapter 9 – Profit and Loss Statement
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The most basic function of any small business is to earn profit for the owner
Profit is the net increase in the owner’s equity as a result of the firm’s operations
Profit is calculated by measuring the firm’s revenue- what it has earned from its
customers from performing a service – and deducting from this its expenses- what
is
has
cost
the
business
to
provide
those
services
Profit = Revenue - Expenses
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Revenue is an inflow of an economic benefit (or saving in an outflow) in the form
of an increase in assets (or decrease in liabilities) that increases owner’s equity
(except for capital contribution)
Revenue will usually be cash, but it does not have to be- it could be debtors or
even stock
Revenue will increase assets- if the service is done for cash then ‘Bank’ will
increase, but services can also be done for credit so ‘Debtors’ will increase
Revenue then represents an increase in owner’s equity that occurs through
business activities, and in most cases will be what the business has earned from its
services, not what the owner has contributed (capital contribution)
Expense is an outflow or consumption of an economic benefit (or a reduction in
inflow) in the form of a decrease in assets (or an increase in liabilities) that
reduces owner’s equity (except for drawings)
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Where as assets refer to future economic benefits- benefits the business still hasexpenses refer to benefits to that have been consumed, and are gone
Expenses will decrease assets (or increase liabilities)- if the expense is paid in
cash then ‘Bank’ will decrease, but it is possible for ‘Stock’ to decrease or if paid
by credit ‘Creditors’ will increase
Expenses represent a decrease in owner’s equity that occur through business
activities, or what the business has consumed to earn its revenues, but not what
the owner has withdrawn from the business (drawings)
Once the Reporting Period is determined, it is important that the calculation of
profit includes only revenues and expenses- this insures relevance in the reports
by including only information useful for decision making
Profit and Loss Statement is an accounting report which details the revenues
earned and expenses incurred during the reporting period
Cash receipts that are revenues are:
 Cash fees- is revenue received from providing a service
 Interest on bank account- a by-product of the business operating a
bank account
Cash Receipts that are not revenues are:
 Capital Contribution- is not a revenue as it is not earned by the
business, but rather contributed by the owner
 Loan- it does not increase owners equity, it increases ‘bank’ but also
increases liabilities (loan)
 GST received- it does not increase owners equity, it increases ‘bank’
but also increases liabilities (GST payable)
Cash payments that are expenses are:
 Wages and Supplies- consumed in the process of providing services
 Electricity (and similar)- is consumed by the business premises
 Interest on mortgage- is incurred as a result of using a mortgage to
pay for the premises
Cash Payments that are not expenses are:
 Mortgage Repayments- is not an expense as is does not decrease
owner’s equity; it decreases ‘Bank’ but also decreases the liability
‘Mortgage’
 GST Settlement- is not an expense as is does not decrease owner’s
equity; it decreases ‘Bank’ but also decreases the liability ‘GST
Payable’
 Purchases of non-current assets- it does not decrease owner’s equity;
it decreases bank and increases non-current assets. Non-current
assets is a future economic benefit rather than an outflow of
economic benefits
 GST Paid- is not an expense as is does not decrease owner’s equity;
it decreases ‘Bank’ but also decreases the liability ‘GST Payable’
 Drawings- is not an expense as its in not consumed by the business
rather withdrawn by the owner
The above cash payment affect an element of the accounting equation other than
owner’s equity
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Like all accounting reports the Profit and Loss Statement states who the report is
prepared for, what type of report it is, and when- which period it applies
The fact that not all cash receipts are revenues, and not all cash payments are
expenses means that it is possible to earn a profit and yet suffer a cash deficit, and
vice versa (incur a net loss yet generate a cash surplus)
Cash Surplus (deficit) measures the difference between cash receipts and cash
payments
Net Profit (loss) measures the difference between revenues and expenses
It is possible to earn a net profit but still suffer a cash deficit due to:
 Drawings
 Loan repayments
 Cash purchase of non-current assets
 GST settlement
The above items have no affect on Net Profit as they are not expenses, but each is
a cash payments and as a consequence will decrease ‘Bank’ which will increase a
cash deficit
It is also possible to incur a net loss, and yet generate a cash surplus due to:
 Loan
 Capital contribution
 GST refund
These items have no affect on net profit as they are not revenues but are all cash
receipts also they will increase ‘bank’ and add to cash surplus
If GST received from customers is greater than GST paid to suppliers, ‘bank’
will increase and maybe another reason why there is more cash than profit
If GST paid to suppliers is greater than GST received from customers, ‘bank’ will
decrease, and maybe another reason why the business has less cash than profit
Using the Accounting Equation will calculate owner’s equity at the end, but the
Balance Sheet must show how that figure was calculated by reporting Net profit
(loss) and drawings
Uses of Profit and Loss Statement are:
1. To aid decision making about the firms operations- by measuring the
firm’s performance, and allow the owner to make appropriate
changes
2. To assess whether the business is meeting its revenue and expense
targets- by comparing Profit and Loss Statement against budgeted
performances
3. To assist in planning for future service activities- by providing a
basis for the next budgeted Profit and Loss Statement, which sets
targets for the future
4. To assess the performance of management- in operating the
business- primarily relating to generating sales and managing
expenses
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Chapter 10- Cash Budgets
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A business cannot be successful if it does not prepare early for what it may face in
the future
Budgeting is the process of preparing reports that estimate or predict the financial
consequences of likely future transactions
The differences between the budgets and the reports that we have done before are:
1. Budgets report future events rather than historical events; they focus
on what might happen rather than what has happened
2. As a consequence budgets use estimates or predictions rather than
actual, verifiable data
Budgets have a role in both planning and decision-making:
1. Budgets assist planning by predicting what is likely to occur in the
future. This allows the owner to prepare for what is likely to occur so
that possible problems maybe managed, and possible opportunities
taken.
2. Budgets aid decision-making by providing a standard (a benchmark) against which actual performance can be measured. This
allows the owner to identify areas in which performance is
unsatisfactory, so that remedial action may be taken.
The information in a budget relies largely on what has happened before- what we
expect to happen this year will depend largely on what has happened last year
Budgeting is a part of a continuous process; budgets should be prepared ,
compared against actual reports to allow problems to be identified, decisions
should be made based on that assessment, and then new budgets should be
prepared for the next period
The information presented in the budget should be based on historical data, but
allowances should be made for changes and the effect of new business decisions
The cash budget is an accounting report which predicts future cash receipts and
payments, determines the cash surplus or deficit, and thus estimates the cash
balance at the end of the budget period
Typical cash receipts a service firm could expect to see in a cash budget might
include:
 Cash fees/takings
 GST received
 GST refund
 Other revenue received (such as interest)
 Cash contributions (capital contribution)
 Loans received
 Cash received from the sale of an non-current asset
Typical cash payments a service firm could expect to see in its Cash Budget might
include:
 Expenses paid (such as wages, rent or advertising)
 GST paid
 GST settlement
 Cash Drawings by the owner
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 Loan repayments
 Cash paid for non-current assets
When reporting creditors and debtors in a budget the GST is reported as a part of
‘creditors’ or ‘debtors’- not sperately
More frequent budgets will be more accurate, and therefore more useful as
benchmarks for comparison. They will also allow for the early detection of
problems, so that corrective action can be taken in a more timely fashion (and can
perhaps stop a small problem becoming large)
It would be wise to prepare budgets for consecutive months to show the effect of
monthly variations. This will allow the owner to identify monthly or even
seasonal trends, and can be useful for identifying when to undertake a particular
cash activity (such as a purchase of non-current assets).
The cash budget aids planning by allowing the owner to prepare in advance for an
expected cash surplus or deficit. That is, the owner will be forewarned if the
business is not generating enough cash or if excess funds will be available. This
forewarning is particularly important if a cash deficit si predicted, because the
cash budget will allow the owner to take steps to address the cash shortage before
it occurs.
Should the budget predict an overall cash deficit, the owner might prepare for this
by:
 Deferring the purchase of non-current assets, or using credit facilities
or a loan for their purchase
 Deferring loan repayments
 Taking less cash drawings
 Making a cash capital contribution
 Organizing (or extending) an overdraft facility
Should the budget predict an overall cash surplus, the owner might plan to use the
extra cash to:
 Purchase more/newer non-current assets
 Increase loan repayments
 Increase cash drawings
 Expand operating activities by increasing advertising, employing
more staff ect.
 Also if the business at the start of the period had an bank overdraft, it
may chose to do nothing and let the surplus bring the bank back into
surplus
The cash budget aids decision making because it sets a benchmark for the
assessment of the firm’s actual cash performance. By comparing budgeted and
actual cash flows, the owner can identify problem areas and act to correct the
problems. Problems identified in the budget may lead to:
 Strategies to increasing cash fees (via promotion, greater advertising,
discounting prices)
 Strategies to decrease cash paid for expenses. The owner must be
careful when reducing cash paid for expenses, as the benefits the
expenses provide are vital in the earning of cash takings; cutting
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expenses may actually make the cash situation worse rather than
better
Cash Variance Report is an accounting report which compares actual and
budgeted cash flows, highlighting any differences (variances), so that problems
can be identified and corrective action taken
Variance is the difference between an actual figure and a budgeted figure,
expressed as favorable or unfavorable
Variances are a result of two main things:
1. The business over-performing or under-performing
2. Or a miscalculation of the budget
A variance is favorable (F) if it Bank will be higher than expected in the budget
A variance is unfavorable (U) if it means Bank will be lower than expected in the
budget
In relation to cash receipts:
 If actual cash received is greater than budgeted, the variance is
favorable, as the closing bank balance will increase more than
expected.
 If actual cash received is less than budgeted, the variance is
unfavorable, as the closing bank balance will be increase less than
expected
In relation to cash payments:
 If actual cash paid is greater than budgeted, the variance is
unfavorable, as the closing bank balance will decrease more than
expected
 If the actual cash paid is less than budgeted, the variance is
favorable, as the closing Bank balance will decrease less than
expected
In a cash variance report, variances are assessed from a cash perspective only
The cash variance report is useful to decision-making as it will clearly show
unfavorable variances that should be investigated so an explanation can be given
for them. The Cash Variance Report also aids planning as is can be used to
prepare the next budget, so that it is more accurate, and thus more useful as a
benchmark and for decision-making.
Cash Variance Report relates to reliability as is will allow us to adjust our budget
for the next period so that figures will be ‘reliable’
When analyzing reports always analyze and comment on the ‘bottom line’ first.
Then analyze and comment on the subtotals. Finally analyze and comment on
specific transactions.
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